The Three Different Ways We Could Set Prices in Healthcare

Image credit: AP Photo/Damian Dovarganes

Image credit: AP Photo/Damian Dovarganes

Out of the three general ways we could set prices in our healthcare system, one is best. Too bad we’re using the other two.

First, I’ll describe each method:

  1. Administrative pricing: This one is very straightforward. The government says, “For procedure A, healthcare providers will be paid X dollars.” Usually the methods for coming up with that dollar amount are sophisticated and rely on the best available data, but not always because they are subject to various political influences and government budgets.
  2. Bargaining power-based pricing: This one is easiest to explain using an example. Think of a small town with only two family medicine docs. One, Dr. Awesome, treats 90% of the town’s residents; the other, Dr. Mediocre, treats the other 10%. All patients are insured by one of four different private insurers, each of which has approximately equal market share. Now think of Dr. Awesome sitting down at the bargaining table with one of the insurers to decide on prices. He says, “If you don’t pay me at least Medicare rates times 1.4, I won’t accept your insurance. I’m serious, I won’t accept anything less.” And the insurer says, “Hey, that’s a horrible deal, but if we stop covering care you provide then most of our policy holders in your town will just switch to one of our three competitors and we’d lose out on even more profit!” Now think of the conversation between Dr. Mediocre and that same insurer. Dr. Mediocre says, “Pay me Medicare rates times 1.4.” And the insurer responds, “No. We’ll pay you Medicare times 0.8. If you say no and we don’t have you listed as a provider in our network anymore, that’s okay because only a tiny percentage of our policy holders are your patients. And we know that you don’t have many patients, so you can’t afford to risk losing 1/4 of them by saying no to the price we offer.” Relative market share between the two parties is the primary determinant of bargaining power, so a bigger market share means you can get a better price.*
  3. Competitive pricing: This is the method used to determine prices in almost every other industry. Here’s basically how it plays out: Competitor A says, “Everyone knows that our product has similar quality to our competitor’s product, so we can’t price it higher than theirs without sacrificing quite a bit of market share. We could sell it for less than theirs to win more market share, but then the price is perilously close to our costs, so we’ll have to do some math to see what the profit-maximizing price/market share combination is likely to be.” Note the one huge condition that is required for this to work: Potential customers must be able to compare the price and quality of all their options, which is starting to happen more and more as better quality information is starting to become available and as prices are becoming more transparent.

Our healthcare system currently relies primarily on number 1 (think: Medicare and Medicaid) and number 2 (think: private insurers and providers setting prices with each other). But which method is best?

If you want to have the lowest possible prices, administrative pricing is the obvious best choice. But that’s only for the short term (as you’ll see), and it does nothing to encourage quality improvement unless you start getting into the treacherous area of performance incentives.

The only thing I’ll say about bargaining power-based pricing is that I don’t like it. I’d rather not have prices that are totally unrelated to costs or quality and instead are determined by relative market share.

Now let me tell you why I like competitive pricing so much. I want our healthcare system to deliver better value right now (Value = Quality / Price), and even more than that I want that value to go up over time as providers and insurers innovate in ways that allow them to decrease prices, increase quality, or both. Competitive pricing is the only method that provides an incentive for competitors to innovate because it rewards the highest-value offerings with increased market share and profit. The other two options don’t do that, which seems like a pretty big downside, don’t you think? I’d be willing to forgo short-term super-low administratively set prices in favor of stimulating innovation that will improve value way more over the long term.

In my next post, I’ll explain how we can shift from bargaining power-based pricing to competitive pricing.

* Do you ever hear those arguments that if public insurers lower their prices any more, providers will just raise their prices for private insurers? Well, now you know why those arguments are mostly hogwash. Providers are already leveraging their relative market share to get as high prices as possible from private insurers, and getting paid less by public insurers doesn’t change that relative market share.

How Backward Integration Is Starting to Fix Healthcare Delivery

A good friend just told me about Montana’s state-run clinics that are only for state employees. Going to the clinic is free for state employees, which means the state is paying for everything. And yet, despite paying for everything, the clinics are doing such a good job of managing diseases that the state is actually saving more money than it’s spending on the clinics.

I’ve talked about the importance of cost-saving prevention before, but my point in describing this example is to illustrate a growing trend in healthcare–a trend that is largely unrecognized, but is starting to fix healthcare. So let’s break it down.

Think of the Montana state government as a company. This company, just like most companies, has suppliers that sell it critical inputs it needs to perform its services. And one of the most important suppliers to this company isn’t obvious: healthcare providers. Think about it–they are supplying the healthcare that keeps employees productive, which is surely a critical input.

And here’s the interesting thing about the relationships companies have with their suppliers: if the supplier’s product is too expensive, or isn’t good enough in some way, companies will sometimes just take over the production of that critical input themselves. This is called “backward integration.” Think of all the ways employers are backward integrating into healthcare, whether it’s having their own salaried physicians or working closely with providers to redesign care processes; they’re all variations on the same theme.

But employers aren’t the only ones with a supplier-buyer relationship with healthcare providers. Insurers depend on providers to supply the healthcare they are guaranteeing to their customers. So are insurers backward integrating as well? YES. Any time an insurer joins up with a provider, it could be seen as an attempt by insurers to backward integrate (ahem, ACOs). And insurers are also going crazy trying all sorts of hands-off approaches to backward integration (if it’s hands-off, can it still be called backward integration?) with things like pay for performance, bonuses for starting medical homes, and probably hundreds of other experiments I’ve never heard of. They are all attempts to exert some degree of control over the unsatisfactory supplier. Or, in other words, to fix healthcare delivery.

So, I guess we could say that employers and insurers are fixing healthcare delivery. Strange, isn’t it?

If We Lower Total Healthcare Spending, Who Will the Money Come from?

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At the recent AcademyHealth Annual Research Meeting in Baltimore, I went to a session on the accomplishments and challenges of community collaboratives. A community collaborative is a pretty cool idea that goes something like this: for a specific community (i.e., city), let’s get all the leaders of the providers and payers in a room (plus a bunch of other stakeholders committed to improving health) and make some decisions collaboratively on how we can fix healthcare in the community. The Robert Wood Johnson Foundation has provided the money to make these things happen in 20 different communities in the U.S. (see Aligning Forces for Quality, and Value-Based Payment Reform).

Sounds like a great idea, right? Well, an interesting challenge has arisen. More and more, these collaboratives are expected to find ways to reduce the total healthcare spending in that community. But so far, they’ve pretty much failed miserably. Why? Well, think about it. Here are all the leaders of payers and providers in that community sitting in a room together saying, “We need to reduce total spending,” but the savings are going to have to come from someone in that room, and none of them are going to say, “Sure, my organization will take one for the team! I’ll have to cut everyone’s pay, but because it’s for a good cause, they’ll love it.”

Does this mean these kinds of collaboratives are utterly useless in terms of lowering total spending in communities? That was the question I (carefully) asked at the end of the session, and one of the panelists gave a really insightful answer. To paraphrase/translate/elaborate on what he said, his answer went something like this:

Yeah, we’re not going to convince anyone in that room to just give up money like that. But what we can do is come up with standardized ways of reporting prices and quality. And when those are standardized across all payers and providers, patients will be better equipped to choose higher-value payers/providers, which, in the U.S., usually means ‘cheaper’ payers/providers. So this standardization will allow total spending to go down by getting more people receiving services from cheaper competitors. Thus, the higher-priced competitors will be the ones who are losing money when total spending goes down, all because we helped standardize quality and price reporting.

I agree. There are still many barriers to getting patients to choose these “higher-value” providers/payers, but this would help solve one of the biggest ones. And with each barrier we overcome, more patients will be enabled to receive higher-value care, which is what everyone wants, right?

Should We Regulate Prices of Hospitals? All-payer Rate Setting’s Allure


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The Bitter Pill article has received a lot of press lately. People reading it have often turned to a simple solution: regulate prices. The most straightforward approach to this is called “all-payer rate setting,” which has been experimented with before in some places in the U.S. and is still used in Maryland. The basic idea is that the government says, “When any provider performs this certain service, he/she will be paid this much for it no matter who the payer is.” And they set prices for every single service. Think of how this would instantly make all chargemasters a thing of the past. And no more worrying about hospitals increasing their bargaining power as they join together to form ACOs. And all that administrative complexity that would be gone (thus decreasing costs a fair amount)!

But there are downsides, too, which are not as obvious and may lead people to jump on the bandwagon of all-payer rate setting ignorantly. First, back to basics:

Total spending on healthcare = price * quantity

Yes, we probably have some quantity problems (running too many scans, etc., which regional variation literature attests to quite thoroughly), but the main reason we spend so much more than other countries is because of the prices. So, here’s the prices equation:

Price = Cost + Profit

What’s making prices too high? Brill makes a strong case that, at least in a lot of hospitals, profit is part of the problem. But what about costs? Is the actual cost of care too high as well? I’ve never seen literature that breaks down exactly how much of our overspending is a result of high profits versus high costs, but I’m going to go out on a limb and say YES, costs are a problem. Evidence of this: even in countries that do a pretty good job minimizing unnecessary services and regulating profits to reasonable levels, healthcare spending growth is still unsustainable, which only leaves cost as the primary culprit. Therefore, any policy (whether it’s meant to regulate profits, improve access, improve quality, or whatever) that creates barriers to cost lowering should be reserved as a last resort.

So, would all-payer rate setting create a barrier to cost lowering? If yes, I don’t like it. If no, let’s consider it.

First, since I’m reading The Wealth of Nations lately, let’s ask Adam Smith what he thinks about the subject:

I shall conclude this long chapter with observing, that though anciently it was usual to rate wages, first by general laws extending over the whole kingdom, and afterwards by particular orders of the justices of peace in every particular county, both these practices have now gone entirely into disuse.

By the experience of above four hundred years [says Doctor Burn] it seems time to lay aside all endeavours to bring under strict regulations, what in its own nature seems incapable of minute limitation: for if all persons in the same kind of work were to receive equal wages, there would be no emulation, and no room left for industry or ingenuity.

Particular acts of parliament, however, still attempt sometimes to regulate wages in particular trades and in particular places. (Emphasis added)

What’s he trying to say? All-payer rate setting would leave “no room left for [cost-lowering] industry and ingenuity”? (If you’d like to see my explanation for why I assume innovations by providers are generally cost-lowering, see here.)

I’ve explained before how taking away the freedom to set your own prices also removes much of the rewards for cost-lowering industry and ingenuity. In short (and simplified), lowering costs without sacrificing quality means you can lower prices more than others and therefore offer higher value than others, and higher value will eventually be rewarded with market share and profits. (Another assumption I’m making: patients preferentially choose higher-value providers, which is starting to be more true, but there are still many barriers to it.)

Back to the big picture: All-payer rate setting reduces the potential rewards for cost-lowering innovations, which I can guarantee will reduce the amount of cost-lowering innovation that goes on. So, yes, all-payer rate setting will be a barrier to cost-lowering innovation. And that’s a huge problem, so let’s look for other ways to fix egregious profits and costs. More to come . . .

Why Fee-for-service Reimbursement Is Bad. Wait . . .

Preface: The sparse blogging of late is because I’ve been working on a paper for publication, but it’s mostly done and I’ll be blogging all about it later.

When someone is arguing that the health system needs an overhaul, one of the most common reasons they cite is that “our health system is built on a flawed foundation of fee for service.” Arguments like this always sound so bulletproof when they rely on vague yet widely accepted assumptions, but let’s think clearly about this, just for a moment.

First, let’s go back to Econ 101 to recall that association does not imply causation. So, when you see a health system based on fee for service that is delivering surprisingly low value, you are seeing an association. It starts to look a lot more like causation when you compare this health system to other health systems in the world that are not built on fee for service but are all delivering much higher value. But it starts to look a lot less like causation when you compare this health system to any other industry and see that nearly all of them are based on fee for service yet somehow delivering excellent value. (I’ll come back to this later.)

So what is fee-for-service reimbursement, really? It is simply one extreme end of a spectrum, and at the other end sits capitation:

1This spectrum is not well understood. People always think of it in terms of incentives (“bad” incentives at the fee-for-service end, “good” incentives at the capitation end), but what is actually being varied as you move from one end to the other? I’ve never heard anyone talk about that. So let’s talk about it; the conclusion will be surprising.

I will say that fee for service is the purchase of a narrowly defined service (e.g., a single doctor visit, a single operation, a single medication), whereas capitation is the purchase of a broadly defined service (e.g., all health care you need for a year). So, breadth of service purchased at one time is really what varies on this spectrum. But in addition to the breadth of the service being purchased, there is another important difference: risk. When you pay for narrowly defined services one at a time, you have all the risk (meaning, if you get sick or break your arm, you’re the one who is financially accountable). And when you pay for a broadly defined service, the party you’ve paid has all the risk (meaning, if you get sick or break your arm, they’re the one that is financially accountable). Note that this is primarily where the “accountable” comes from in accountable care organizations–they have the financial risk, not the patient.

This is a spectrum because a service could sit at any point along it. For example, Qliance offers flat-rate, no-limit primary care; they are financially accountable for anything that could be considered primary care. Another example is episode-based billing, where the patient pays a single lump sum in exchange for a guarantee that the provider will do everything necessary to treat the specified medical condition. An interesting side note is that even a typical fee-for-service doctor visit is not truly fee for service in the sense that the patient has all the risk; at least, last time I checked doctors don’t make patient pay larger copays any time appointments run longer than the allotted 15 minutes.

2So what can we conclude from this discussion? Is fee for service actually bad?

Being too far at the fee-for-service end of the spectrum can definitely be bad if it means patients are expected to coordinate complex care by themselves. But being too far at the capitation end of the spectrum can also be bad if it means patients are not at all financially responsible for the services they choose to consume and are also stuck having to get all their care from one source that will inevitably provide less-than-exceptional quality for some services.

This means we need to find the perfect point somewhere in between the extreme ends of the spectrum where our health system will deliver optimal value. This point obviously depends on the service and the individual involved, as well as who can bear risk most effectively, but the way to think about it is using the “jobs” principle as taught by Clay Christensen. When a person enters the health system, it’s because they have a “job” they want to get done. That job generally isn’t something as narrow as to get an x-ray; more likely, their job would be to fix a suspected broken arm, so they’re looking to purchase all the services together that can fulfill that job. The job could also be broader, like to have the peace of mind that they have little to no healthcare-related financial risk and can just go and get care from one source no matter what comes up, or also to have help to keep healthy and thereby reduce care-requiring episodes (think: Kaiser Permanente and similar integrated delivery systems).

If we want to successfully redesign our healthcare delivery system (isn’t that all the talk these days?), we need to understand that fee-for-service isn’t intrinsically bad; the only bad thing is missing the sweet spots on that spectrum.

One final, crucial point: Yes, overhaulists* properly attribute many of the problems in our system to it sitting too far at the fee-for-service end of the spectrum (e.g., overtesting, overtreating, fragmentation), but they have overlooked what has caused the system to fail to adjust itself to a more optimal, jobs-focused point on the spectrum, as other industries do. This has everything to do with value not being financially rewarded in our system, and it is the topic of the publication I’ve been working on, as well as many future blog posts that will start to lay out the solutions more cohesively (after my publication comes out). More to come!

* My term for someone who believes the entire health system needs to be overhauled

UPDATE: Added a paragraph or two for clarity.

Why Aren’t Prices Transparent in Healthcare?

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I had a friend ask me that (the title of the post) a few days ago. He prefaced the question by saying he’s asked a few different people and knows already that there isn’t a simple answer to it. But those other people he asked misled him. The answer actually is quite simple. And why nobody is explaining this clearly, despite all the talk about price transparency in healthcare these days, is a symptom of a general lack of understanding of how industries actually function.

Prices are transparent in healthcare–the insurer knows exactly how much they’ll pay each healthcare provider for every service they cover. The problem isn’t transparency. The problem is that the party making the decision on where to seek care is not the same party that bears the financial consequence of that decision. Who chooses where to seek care? The patient. Who bears the financial consequence of that decision? The insurer. Therein lies the rub.

Think about two different scenarios. In the first, the patient will have both responsibilities. Patients would start to actually consider whether the extra $5,000 they would have to pay to go to Provider B for their cholecystectomy would be worth it as opposed to just going to Provider A. Is Provider B’s quality actually that much better to make it worth the extra $5,000? If not, patients will probably choose Provider A. And what happens when patients all start being unwilling to pay unjustifiably high prices? Provider B will either have to lower prices (goodbye crazy price variations!) or continue to deal with a large number of unused operating room hours. Patients win because they get better value, and high-value providers win because they get patients. In this situation, the decreased expenditures on healthcare are taken from the low-value providers. Who would argue against that? In this case, even the “I’m better than the average physician” belief that 100% of physicians have (statistically impossible as it may be) will help to decrease healthcare expenditures.

This pairing of both responsibilities in patients is actually happening, by the way. Why do you think insurers are trying out reference pricing, where they just commit to put a set dollar amount toward a given procedure and have the patient cover the difference if they choose a provider who charges more than that? And what about tiered plans, where patients choosing to go to the more expensive hospitals (the ones in the higher tiers of the insurance plans) have to pay a larger copay? And what about high-deductible plans for services below the deductible? These are all doing the exact same thing but in different ways: making the person who chooses where to get care the same person who bears the financial consequences of the decision. And providers with higher value are being rewarded with increased market share (volume).

In the second scenario, the insurer will have both of those responsibilities. It’ll still bear the financial consequences, of course, but now it’ll also be the one that tells patients exactly where to go for care. Patients wouldn’t like this, of course, but what would happen? Insurers would send every patient to the cheapest provider that meets minimum quality standards. Unlikely to ever happen? For run-of-the-mill procedures, probably it won’t ever happen. But for incredibly expensive one-time procedures, it already has. I heard a story about an insurer that did this with liver transplants (which, all told, is estimated to cost over $500,000 dollars). The insurer asked around to all the reputable local hospitals and got the cheapest bid for each patient. Then they sent each patient to the lowest-bidding hospital. The insurer saved a bundle. And the hospitals that could offer lower prices (possibly because they had lower costs somehow) were rewarded with volume. Ah, that whole reward value with volume thing again. It’s beautiful.

One final real-world example. ACOs. So far, one major way they’ve saved money is by sending patients to cheaper specialists. Let’s apply the principles we’ve just talked about to understand what’s going on. The referring provider is generally the party charged with making the decision of where the patient will go for a specialist visit. (The doctor says, “You need a specialist to look at this. Here’s the phone number for a good doctor, so go see her.” The patient says, “Okay, Doc, whatever you say. I’ll go see her.”). And when the referring provider is getting a bonus for keeping overall costs down, he now also bears the financial consequence of sending patients to expensive specialists because it’ll cost him his bonus. Now that you understand the principle of those two responsibilities needing to be invested in the same party, the world starts to make sense; you start to actually be able to predict whether something will work or not.

So now when you hear people complaining about our “horrendously evil system of third-party payment,” you’ll know that it’s not intrinsically a bad thing. It’s only bad when it results in a separation of those two responsibilities, the decision-of-where-to-seek-care responsibility and the financial responsibility.

How to Reward Value Instead of Volume

Who has heard the favorite healthcare reform saying these days? “We need to reward providers for value, not volume!” It has almost become cliche. And conventional wisdom would teach that something touted frequently would be well thought through by the people touting it; but we all know conventional wisdom is often wrong. (Did I just say that the knowledge that conventional wisdom is often wrong is conventional wisdom?) I admit that I have not read everything by everyone doing the touting, but I’ve never heard anyone break down exactly how we can reward value instead of volume. So I’ll tell you.

There are only two ways to do it: a dumb way and a smart way. But first, let’s review how a healthcare provider makes money:

Revenue = Price x Quantity

Do you see that there are only two components (that we can control, at least) that determine how much money a company makes? We can change the prices we pay them or the quantity they sell.

Now, let’s suppose we are able to identify an objectively highest value healthcare provider out there. Let’s further suppose that we want to reward this high-value health system for its amazingly high value so that it can be financially rewarded for being so awesome and so (we hope) others will copy them to have high value and be rewarded, too. How can we do it? Let’s look at our two options:

Increase price: You’ll recognize this as what Medicare is trying to do. Will it have the intended effect? Probably. High-value providers will be rewarded with higher prices. But hold the phone–isn’t our true intended effect to get society the highest-value healthcare we possibly can? So how are we maximizing value if we’re raising prices? Raising prices lowers value. So we’re identifying the highest-value providers and then lowering their value. Hm. Ah, but maybe there will be an overall aggregate effect of higher value because we won’t raise prices much, but we’ll get lots of low-value providers to improve their quality. I guess. But all this seems to be doing is increasing the total money we pay on healthcare, which is not a good idea right now. So I call this the dumb approach. But people haven’t thought hard enough to know there’s also a smart approach . . .

Increase quantity: What this means is getting more people to the highest-value providers, so now we’re rewarding value with volume. Their hospital beds are full, their specialists are performing lots of high-margin surgeries, etc., and they are rewarded handsomely for being high value. Not only does this reward the high-value provider, but look what happens to patients–they get to have higher-value care because they’re going to the high-value providers! In other words, society collectively will be receiving higher-value healthcare. And the low-value competition, meanwhile, will not be so busy anymore, they’ll start to lose money, and they might actually go out of business UNLESS they improve their value as well. That’s quite an incentive to change (probably the most powerful one, actually).

So why aren’t we doing this rewarding value with volume thing? I could list a bunch of reasons why we’re not, but that wouldn’t be very clear thinking now, would it? Instead, I’ll ask this: Who is deciding which providers patients will go to? Whoever is making that provider selection (sometimes it’s the insurer or employer, sometimes it’s other providers, usually it’s the patients themselves) needs to (1) have the price and quality information necessary and be able to determine which provider they think is the highest value and (2) bear the financial consequences of their choice (otherwise they’ll just choose the highest quality every time without regard for price!). If the provider-selecting party can meet both of those conditions, they will be making what I call value-sensitive provider selections.

In summary, policy ideas to reward value with higher prices will not do much for aggregate healthcare value our society is purchasing. But policy ideas that can get those 2 conditions fulfilled for the parties making the provider selections will successfully reward value with volume and concomitantly provide low-value providers with an ultimatum to either improve value or go out of business.

So the questions we should be asking ourselves if we want to “reward providers for value, not volume” is How can we remove the barriers to value-sensitive provider selection?” When will I write another post that enumerates all of the most salient barriers and how to remove them? Ask me tomorrow, but not today.